Market prices and rates continually change, driving the value of securities and other assets up and down. These movements create the potential for loss, as price volatility is the engine of market risk.Market risk takes many forms depending on the underlying asset. From a financial institution's perspective, the key forms are equity risk, interest rate risk, currency risk, and commodity price risk.

 

Each of these markets has its own risk management tools and methodologies.However, across all these markets, market risk is driven by the following.

• General market risk: This is the risk that an asset class will fall in value, leading to a fall in the value of an individual asset or portfolio.

• Specific market risk: This is the risk that an individual asset will fall in value more than the general asset class.

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Market risk can be managed through the relationships between positions. The diversification benefits of a large equity portfolio, for example, form the bedrock of investment risk management. However, market risk also arises from these relationships. For example, an equity portfolio designed to track the performance of an equity market benchmark might fail to track it perfectly—a special form of market risk. Likewise, a position intended to balance out, or hedge, another position or market price behavior might do so imperfectly—a form of market risk known as basis risk. For risk managers, this mismatching of price movements is often a bigger problem than any single market risk exposure. For example, a commodity risk manager might be using crude oil futures to hedge jet fuel, only to find that the normal price differential between the two has widened.